Machinery Stocks to Bear the Brunt of Trump’s Tariff Plan

On Mar 8, President Donald Trump implemented a tariff of 25% on steel imports and 10% on aluminum imports from all countries except Canada and Mexico to counter an "assault on the country" by foreign competitors. This is a bid to reinforce the American steel and aluminum industries which had long been reeling under the onslaught of cheap imports and suffered significant reduction in production and employment.

Cheap Imports a “Threat to National Security”

At the behest of the Trump administration last year, the U.S. Department of Commerce’s carried out investigations under Section 232 of the Trade Expansion Act of 1962, to determine whether the imports pose a threat to national security. Reports were submitted to the President in January 2018.

The reports concluded that the quantities of steel and aluminum imports “threaten to impair the national security,” as defined by Section 232. In fact, U.S. steel imports were nearly four times the company’s exports, and that aluminum imports had risen to 90% of total demand for primary aluminum. Six basic oxygen furnaces and four electric furnaces have closed since 2000 and employment slumped 35% since 1998. In the aluminum industry employment fell by 58% in the 2013-2016 period with six smelters being shut down, and only two of the remaining five smelters operating at capacity, despite growth in demand.

Taking the scenario into consideration, the Commerce Department recommended that President Trump take action to protect the long-term viability of the nation’s steel and aluminum industries.

Mexico, Canada Exempted

The exemption of Mexico and Canada is a significant concession from Trump’s initial plan for broad-based tariffs on steel and aluminum given that Canada is the largest steel exporter to the United States, accounting for roughly 17% of total U.S. steel imports in 2017. Mexico comes in the fourth position with around 9% share of the imports market.

The exclusions of these countries are however dependent on the outcome of the North American Free Trade Agreement (“NAFTA”) renegotiation talks that are underway. There will be provisions for other countries to apply for exemptions provided their imports do not hurt the U.S. economy.

Will the Consequences be Far Reaching?

The announcement has already caused serious friction within the Republican Party and stoked fears of a trade war. It is likely to lead to imposition of retaliatory tariffs on important American exports to other countries, which might hurt the U.S economy.

The European Union (“EU”) plans to strike back by imposing tariffs on iconic U.S. brands. Brazil, the second-largest exporter of steel to the United States with roughly 13% share of total imports last year, also pledged to take “all necessary actions” to protect its interests. South Korea, which comes after Brazil in terms of imports, stated it may file a complaint to the World Trade Organization.

China has also warned that it will assess any damage caused by the tariffs and “firmly defend its legitimate rights and interests”. Though China only accounts for 2% of U.S. steel imports, it is the world’s biggest producer of steel accounting for around half of the global production. Its massive industrial expansion has led to dumping excess steel into global markets.

Relief for Steel & Aluminium Industry, Concern for Others

Per the recommendation of the Commerce Department, the imposition of tariff on imports would increase domestic steel production from its present capacity of 73% to approximately an 80% operating rate and for aluminum it is likely to rise from 48% to 80%. These are the minimum rates needed for the long-term viability of the industry. The tariffs are welcome news for American steel makers as it will lead to expected lower imports into the United States, which would in turn boost demand for American steel. This will provide the domestic players with more pricing power.

However, this move has left have left consumers of the metals ranging from construction, manufacturers of auto, aircrafts and machinery to beverage producers, worried that the higher tariffs will inflate their manufacturing costs. This will make them less competitive in exports market and many have warned that could cut into profits and ultimately spur layoffs.

Will the Tariff Hurt Machinery Stocks?

Steel and aluminum are intermediate goods and thus the imposition of tariff will adversely affect other manufacturers and hurt margins. Also retaliation by U.S. trading partners could hurt companies more reliant on overseas revenues. Another major concern is that U.S. farm exports could be hit hard by the retaliatory policies of steel-exporting countries. This further exacerbates the troubles of farm equipment makers, which have been battling sluggish domestic agricultural demand for the past few years.

Caterpillar Inc.CAT, the world's largest manufacturer of construction and mining equipment, sells more than half of its machines outside the United States. Per the Director of investor relations, Amy Campbell, these tariffs could hike not only imported but also domestic steel prices, putting the company at a disadvantage against its non-U.S. competitors.

As it is, Caterpillar's supply costs rose at their quickest pace in a year’s time in quarter ended December. The company is still assessing what impact the current tariff hike would have on its supply costs going forward. The company has been using long-term supply contracts which could be a safeguard against increased costs for six months at most.

Another major player in the sector, Deere & CompanyDE, one of the world's foremost producers of agricultural equipment as well as a leading manufacturer of construction, forestry, and commercial and consumer equipment will be affected by this move. The annual increase in Deere's costs in the latest quarter has been the steepest in at least five quarters.

Caterpillar and Deere have both substantially improved business model delivering better-than-expected margin, earnings, and cash flow performance despite weak mining and agricultural conditions over the past few years. Efforts to lower costs through consolidation or closure of facilities and reduction of workforce helped sustain margins. These mammoths will be able to absorb the higher costs considering that the proportion of the higher steel costs is much lower considering they are earnings billions in profits. They will be able to raise prices to recover the higher input costs and deliver strong margins, albeit with a potential lag of a quarter or two.

However, smaller players like The Manitowoc Company, Inc.MTW, Terex CorporationTEX with lower pricing power than Caterpillar and Deere will be hit hard by the policy. Manitowoc is touted to take the biggest hit among the manufacturing companies. The crane manufacturer has been incurring losses, struggling with lackluster demand for its products. It will be difficult for the company to raise prices to combat raw material inflation.

Terex Corporation’s President and CEO John Garrison sent out a letter explaining “the impact of the rising cost of steel is too large and too sudden” for the company to absorb. The company is adding a steel cost surcharge on its equipment which will cover a portion of the cost increases and will remain separate and transparent from its base prices.

In addition to the stocks discussed above, would you like to know about our 10 finest buy-and-hold tickers for the entirety of 2018?

Last year's 2017 Zacks Top 10 Stocks portfolio produced double-digit winners, including FMC Corp. and VMware which racked up stellar gains of +67.9% and +61%. Now a brand-new portfolio has been handpicked from over 4,000 companies covered by the Zacks Rank. Don’t miss your chance to get in on these long-term buys.